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Dark days for Rio and BHP?

As global markets rally, Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) have been hit with some bleak iron ore forecasts.

The Dow Jones Industrial Average (Index: ^DJI) grew for the fourth consecutive day in a row, up 128.78 points to 14,802.24. But it’s not all good news yesterday. World Steel director general Edwin Basson told reporters that capacity in iron-ore supply will be achieved between 2014 and 2017 but demand is reaching a slow growth period.

As more mines come online throughout the world, particularly in Brazil and Australia, the world will see excess supply of iron ore and prices will fall. According to the World Steel Association a surplus of 100 million tonnes will be evident in 2014 and about 200-250 million tonnes in 2017.

Dow Jones Newswires reported that 1 billion tonnes of iron ore was traded last year and approximately 70% of that went to China. However, with growth slowly stabilising in China, new mines which have come online or are due to come online in the near future will face reduced demand and heightened competition from the bigger miners worldwide.

As a result, price volatility will occur and according to Mr Basson “it can be very, very difficult for the steel industry to absorb volatility of $20-$30 a ton. And we don’t think hedging really exists.” BHP’s interim results released in February showed the impact of iron ore price variances represented US $3.16 billion when compared to the previous corresponding period, but was predicted to account for 26% of the company’s growth contribution between FY12 and FY14.

Rio announced, in its 2012 annual report, that underlying financial results reflected iron ore production and shipment. The report also reaffirmed that they are the second-largest producer supplying the global seaborne iron ore trade and identified China as one of its key sales destinations.

It comes as no surprise that both have had similar trading patterns on the S&P/ASX 200 index (^AXJO) (ASX:XJO) this past year.

Foolish takeaway

BHP and Rio’s price to earnings ratios of 12.25 and 10.85 suggest that the market is feeling uneasy about the current climate for iron ore trading. These two Australian mining behemoths account for approximately 11% of the ASX 200 and have a combined market capital of approximately $132 billion. It’s too early to tell how the big two will react to the eventual volatility that will arise, but you can be assured that they will do whatever it takes to turn a profit out of the ground.

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More reading

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool contributor Owen Raszkiewicz does not own shares in any of the mentioned companies.

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